Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of HRL Holdings Limited (ASX:HRL) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.
See our latest analysis for HRL Holdings
The method
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
| 2019 | 2020 | 2021 | 2022 | 2023 | |
| Levered FCF (A$, Millions) | A$0.35 | A$2.75 | A$6.90 | A$8.07 | A$9.36 |
| Source | Analyst x2 | Analyst x2 | Analyst x1 | Est @ 17%, capped from 48.12% | Est @ 16%, capped from 48.12% |
| Present Value Discounted @ 8.55% | A$0.32 | A$2.33 | A$5.39 | A$5.81 | A$6.21 |
Present Value of 5-year Cash Flow (PVCF)= AU$20m
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today’s value at a cost of equity of 8.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = AU$9m × (1 + 2.8%) ÷ (8.6% – 2.8%) = AU$166m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$166m ÷ ( 1 + 8.6%)5 = AU$110m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$131m. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of A$0.26. Relative to the current share price of A$0.17, the stock is quite undervalued at a 37% discount to what it is available for right now.